A bear market is commonly defined as a stock market decline of 20% or more. Bear markets are hard to anticipate, or to manage. They start out looking like a routine market dip, then a correction, followed perhaps by bargain-hunting that is soon revealed to have been premature.
By the time the bearish trend is inescapably obvious, stock prices are already down, forcing those who haven't pared risk from portfolios to wonder whether it still makes sense to do so, or whether that would just compound the cost of their unsuccessful attempts to time the market.
Inaction by default is never the right answer, if only because bear markets tend to stick around for more than a couple of months. The 26 distinct declines of 20% or more in the S&P 500 index between 1929 and 2021 lasted 289 days on average, according to Ned Davis Research.
As a result, investors likely have more time than they think to respond to the stock market's sagging fortunes, whether by adopting prudently defensive portfolio positioning or by speculating on continued declines.
- The average bear market lasts long enough to give investors plenty of time to respond.
- Diversifying one's portfolio and favoring higher-quality stocks can curb bear market risks while increasing long-term returns
- Defensive stock sectors including consumer staples, utilities, and health care tend to outperform during bear markets.
- Government bonds offer important diversification benefits and the potential of strong returns in a recession.
The first thing to do in a bear market is to make sure your portfolio is properly diversified between a variety of asset classes, not just stock market sectors. Diversification tamps down the volatility that tends to increase during bear markets and can subject investor portfolios to unnerving fluctuations.
One study of returns during the Great Depression found that a portfolio with a 30% allocation to U.S. stocks, a 50% weighting in bonds and 20% in cash would have provided deflation-adjusted annual returns averaging 7.3% between September 1929 and February 1937, in line with the average real return between 1929 and 1998. The 30/50/20 portfolio even outperformed one 100% invested in bonds, underscoring the benefit of diversification.
Among equities, defensive stock market sectors including consumer staples, utilities, and health care have outperformed during bear markets. The goods and services these sectors supply tend to be in demand regardless of economic or market conditions. They also generate plenty of cash, supporting relatively high dividend yields. These sectors are home to many large-cap companies with strong balance sheets, whose shares tend to hold up better during bear markets than small-cap or growth stocks.
While riskier stocks are never more so than during a bear market, there is evidence they also haven't outperformed safer ones in the long run. That suggests a portfolio purge of the riskier stocks during a bear market may pay longer-term dividends as well.
With stocks expected to decline further by definition in the middle of a bear market, why wouldn't an investor avoid them altogether? Bear markets often induce panic selling that can tempt anyone to liquidate stocks in favor of cash or short-term government bonds.
Trouble is, few investors can expect to reliably time the market. Many investors who sell during a downturn will miss out on the sharp rallies that usually mark the bear market's end, significantly lowering their long-term returns. Once they miss the market turn, some are likely to continue digging in their heels, remaining underinvested for longer.
While getting out of stocks will often seem like the prudent move during a bear market, in fact it amounts to an incredibly risky bet on your own market timing abilities and against the stock market's long record of fully recovering its bear-market losses.
Investors looking to minimize equities risk or to take advantage of tactical opportunities during a bear market can choose from a variety of instruments. They include long-term Treasury bonds likely to appreciate if the bear market is followed by a recession, as well as inverse ETFs, short positions on individual stocks, and put options for capitalizing on short-term declines in stock prices.
Structured investment products including annuities can also offer downside protection, while limiting your upside. All hedges have a price, whether it's expressed in the form of the option premium paid or, less obviously, the cap on an annuity policy holder's maximum return. Diversification and de-risking of an equity portfolio can provide comparable benefits at a lower cost.
The arrival of the COVID-19 pandemic led to a short but violent bear market that bottomed on March 23, 2020 with the S&P 500 down nearly 34% in five weeks. The S&P 500 reclaimed its prior high by Aug. 18, 2020.
Shopping for Bargains
Because every bear market in the past was ultimately followed by higher share prices, all of them with the benefit of hindsight presented chances to buy stocks on the cheap. Dollar-cost averaging capitalizes on such opportunities by investing in stocks in fixed, regular dollar increments, say, $500 every month. The strategy lets you buy more equity at lower prices and less at higher ones.
An investor confident about a bear market's impending end could also buy the riskier stocks that tend to outperform in the early stages of the recovery. Of course, those are also the stocks likely to get savaged if the hoped-for bull market turns out to be another bear market rally.
The Bottom Line
A bear market is not for the faint-hearted, nor is it usually the right time to take outsized risks. And that's just as true for the risk of selling all your stocks as the risk of being fully invested in equities. Diversifying one's portfolio and prioritizing strong, well-capitalized balance sheets over hype when it comes to stock selection can pay off huge even if prompted by a bear market.